Monetary Policy and the Term Structure of Interest Rates

   (204 K)

This paper addresses a prominent empirical failure of the expectations theory of the term structure of interest rates under the assumption of rational expectations. This failure concerns the magnitude of slope coefficients in regressions of short rate (or long- rate) changes on long-short spreads. It is shown that the anomalous empirical findings can be rationalized with the expectations theory by recognition of an exogenous random (but possibly autoregressive) term premium plus the assumption that monetary policy involves smoothing of an interest rate instrument -- the short rate -- together with the responses to the prevailing level of the spread.

Published:

• Economic Quarterly, Federal Reserve Bank of Richmond, Vol. 91, no. 4, (Fall 2005), pp. 1-21 ,
• Published as "An Optimizing IS-LM Specification for Monetary Policy and Business Cycle Analysis", Journal of Money, Credit and Banking, Vol. 31, no. 3, part 1, (August 1999): 296-316.

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